Tax expenditures are deviations from the basic tax structure that reduce taxes for specific activities, taxpayers or groups of taxpayers. They’re established by provisions in tax law that provides special exclusions, exemptions, deductions, credits, preferential rates of tax or deferral of tax liability.
Tax expenditures enable targeted groups to reduce their taxes relative to the “basic” tax structure.
Tax expenditures are adopted to encourage certain types of behavior or provide financial assistance to certain taxpayers. These include attract business or economic activity; assist nonprofits; support “deserving” groups of individuals, such as seniors and veterans; and correct inequities in the overall tax system by exempting certain products from the sales tax.
Tax expenditures alter the distribution of the tax burden or create incentives for taxpayers to change economic behavior. They can provide economic benefits or offer an alternative to direct governmental appropriations. Many refer to tax expenditures as “spending via the tax code.”
Tax expenditures exist in federal and state tax codes (which vary state by state). Each state makes a policy decision about which aspects of the tax code will be altered and for whose benefit. Tax expenditures can apply to individuals or corporations or even nonprofits.
Impact of tax expenditures
Tax expenditures reduce the amount of revenues that a government would normally receive. For example, in the federal tax code the value of “forfeited” revenue is $ 1.7 trillion. That is more than total spending for Medicare, Medicaid and defense. States also have a list of tax expenditures. New Jersey, for instance, has an estimated $28 billion in tax expenditures.
A key point: Tax expenditures are not loopholes or earmarks that are slipped into the law to benefit a handful of well-connected people. A loophole allows the tax law to be circumvented; an earmark is a directed spending item for a specific project.
In contrast, tax expenditures are specifically crafted in statute to allow a special exclusion, exemption or credit that usually benefits tens of millions of taxpayers. The three largest tax expenditures in the federal tax code, totaling $450 billion, are for employer-sponsored health plans, reduced rates on capital gains and employee benefits for defined pension plans. Other tax expenditures include the earned income-tax credit and deductions for home mortgage interest.
Tax expenditures principally benefit higher-income people and corporations. In the federal tax code, for example, 70% of all tax expenditures benefit the top 5% of taxpayers. Similar situations exist in the states.
Are tax expenditures good policy? Well, maybe. If we eliminated all tax expenditures we could easily balance the federal budget. State governments, including New Jersey, would have additional revenue to spend on needed programs, or income-tax rates could be reduced. But many people would complain if their particular benefit was reduced. They might argue for eliminating benefits to corporations, but not their tax expenditures. Corporations would have similar views, arguing that getting rid of their benefits would impact the bottom line, limit capital investments and limit competitiveness.
The NJ situation
New Jersey issues an annual Tax Expenditure Report. Tax expenditures are divided into four main categories: exemptions, exclusions, deduction and credits. A separate category shows property-tax relief spending.
The largest tax expenditures are for income, sales and corporate taxes. The report contains descriptions of each tax and related information. For example, did you know that there is a reciprocal agreement between New Jersey and Pennsylvania, so compensation is taxed in the state where you live. But there is no such arrangement with New York, so New Jersey residents working in New York pay income tax to New York — with a loss of $ 4.2 billion to New Jersey. New Yorkers working in New Jersey pay taxes to New Jersey, which offsets a small portion of the loss.
Because of recent controversy it would be easy to assume a big tax loss is associated with corporate tax incentives. Not true. Last year, the state “lost” $370 million — before adjusting for offsetting tax benefits. Instead, the major tax loss actually amounted to $28 billion (as follows).
Tax expenditures for New Jersey are likely greater since the report contains a section titled, “Tax Expenditure That Do Not Have an Estimate.” I count 105 expenditures for which the Treasury is not able to make a reasonable tax-loss estimate. Some examples include life insurance payments, durable medical equipment purchases and medical savings account contributions. Estimating is inherently imprecise as it counts projected dollars that are not collected. In these situations, there is simply no basis for a reliable estimate.
In general, tax expenditures harm the efficiency and effectiveness of the tax system. Economic literature identifies four key shortcomings: the tax base is narrowed; inequities are created across taxpayers; benefits disproportionally accrue to high-income folks; and they are much less transparent than direct spending.
More important, tax expenditures are expensive and recur each year. The Pew Charitable Trusts suggests most states, including New Jersey, do not routinely review these preferences because they are not part of the annual budgetary process. With no one watching, it is easy to lose track of who gets these preferences and what the public receives in return.
But no matter how outdated or arcane, each tax expenditure has a constituent. Many of the preferences involve children, seniors, veterans and corporations. Thus, policy change is difficult but in my view certainly no more challenging than direct-spending decisions.
The state should systematically review tax expenditures. The following questions are appropriate: Who exactly is benefiting and is the benefit to groups really in need of assistance? Perhaps we should consider these criteria for each tax expenditure:
- What are its goals and objectives?
- How does it affect recipients’ behavior?
- What are the major economic effects — both intended and unintended?
- How much revenue is reduced?
- What are the administrative costs?
- What groups are most affected?
- Do the benefits of the tax expenditure justify the costs?
And most important: Are there alternative policies that could achieve the same result more effectively or efficiently, such as straightforward and visible appropriations?
These previously committed revenues, for instance, could be a solution to some of the underfunded needs in the state, such as school aid, transportation, criminal justice and health care. Furthermore, a detailed and objective review might raise questions of preferential treatment and equity. Alternatively, it might come to light that there is little evidence the intended purpose of the tax expenditure has not been achieved.
The principal reason for the annual Tax Expenditure Report is to force decisionmakers to reflect on each tax expenditure and its impact on the overall fiscal climate of the state. It’s important that the governor and Legislature review these tax expenditures every year.